Hedge funds and hedge funds of funds have evolved from a cottage industry to an important area for institutional investment in the past five-10 years and inflows from sophisticated investors such as pension plans and endowments are transforming the industry. Below I take a look at what changes are afoot.

The underlying mathematics of risk measurement is developing to allow risk to be more appropriately appraised within hedge funds and funds of funds. Hedge fund returns do not usually follow a normal distribution and implied risk distributions can sometimes take strange shapes that reflect the esoteric nature of instruments traded by some types of hedge fund. Newer mathematical techniques can be used to assess such distributions, especially in the left hand tail. The left hand tail of a distribution measures the propensity for very bad things to happen and improved modelling and estimation of this part of the distribution allows much better analysis and appraisal of worst case events in both operational and portfolio driven instances. As a result, it will be possible to construct hedge fund of funds portfolios with much better estimation and control of downside, albeit at the expense of some upside, should investors wish for such portfolios.

Those that have already invested in hedge funds have usually done so through multi strategy hedge funds of funds. Going forward, we are seeing a desire by such investors to augment the returns of their existing hedge fund investment by adding hedge funds of funds with more specific mandates eg, fully market independent hedge funds of funds, geographically focused hedge funds of funds and strategy focused hedge funds of funds. This is a reaction to the decreasing volatility (and sometimes returns) from multi strategy hedge fund of funds. This core/satellite approach will lead to growing specialisation in hedge funds of funds and fits well with the bifurcation in the development of the hedge fund of funds world between mega-sized hedge funds of funds that offer broad exposure to the hedge funds universe and the more targeted, smaller hedge fund of funds.

Hedge funds of funds are being seen less as a mystical source of steady returns and more as alpha-generators that are useful and flexible building blocks in the broader scheme of things. Here I think that we are only at the tip of the iceberg in terms of structured solutions that can be built using hedge funds of funds. Innovative structures have already been built importing beta into hedge funds of funds yielding equity or bond index + hedge fund alpha style returns (although referred to as portable alpha structures, it's the beta that's imported!). Future products will include the mixing and netting of long only and long/short portfolios (why be long in one product and short the same thing in another) and also increase use of hedge fund alpha in LDI structures.

The current structure of pension plans using investment consultants to advise on which off-the-peg product to invest in is now evolving. Increasingly in the hedge fund of funds world, pension plans have the assets to demand a bespoke fit rather than the best available off-the-peg product, resulting in hedge fund of funds and consultants working together to gauge what is the ideal portfolio for the pension plan and constructing the resulting perfect fit. If that sounds like hedge fund acting as consultants then equally so, some consultants have began investigating single manager hedge funds (although generally only in the equity long/short area). Going forward, I see hedge funds of funds becoming much more solutions based businesses, working more in partnership with investment consultants.

Above we have seen how hedge funds of funds have developed in terms of sophistication and product, in line with the underlying hedge fund world but also with the growth in sophisticated institutional investors in this area. This evolution has much more to offer and the future for hedge funds of funds is set to be an exiting and innovative time.

Chris Jones is CIO at Key Asset Management in London